The Methodology of Positive Economics

Source: Essays in Positive Economics (1953) publ. University of Chicago Press. Just part of one essay is reproduced here.

V. Some Implications for Economic Isuses

The abstract methodological issues we have been discussing have
a direct bearing on the perennial criticism of “orthodox”
economic theory as “unrealistic” as well as on the attempts
that have been made to reformulate theory to meet this charge.
Economics is a “dismal” science because it assumes
man to be selfish and money-grubbing, “a lightning calculator
of pleasures and pains, who oscillates like a homogeneous globule
of desire of happiness under the impulse of stimuli that shift
him about the area, but leave him intact”; it rests on outmoded
psychology and must be reconstructed in line with each new development
in psychology; it assumes men, or at least businessmen, to be
“in a continuous state of 'alert,' ready to change prices
and/or pricing rules whenever their sensitive intuitions ...
detect a change in demand and supply conditions;” it
assumes markets to be perfect, competition to be pure, and commodities,
labor, and capital to be homogeneous.

As we have seen, criticism of this type is largely beside the
point unless supplemented by evidence that a hypothesis differing
in one or another of these respects from the theory being criticised
yields better predictions for as wide a range of phenomena. Yet
most such criticism is not so supplemented; it is based almost
entirely on supposedly directly perceived discrepancies between
the “assumptions” and the “real world.” A
particularly clear example is furnished by the recent criticisms
of the maximisation-of-returns hypothesis on the grounds that
businessmen do not and indeed cannot behave as the theory “assumes”
they do. The evidence cited to support this assertion is generally
taken either from the answers given by businessmen to questions
about the factors affecting their decisions — a procedure for testing
economic theories that is about on a par with testing theories
of longevity by asking octogenarians how they account for their
long life — or from descriptive studies of the decision-making
activities of individual firms. Little if any evidence is
ever cited on the conformity of businessmen's actual market behaviour — what
they do rather than what they say they do — with the implications
of the hypothesis being criticised, on the one hand, and of an
alternative hypothesis, on the other.

A theory or its “assumptions” cannot possibly be thoroughly
“realistic” in the immediate descriptive sense so often
assigned to this term. A completely “realistic” theory
of the wheat market would have to include not only the conditions
directly underlying the supply and demand for wheat but also the
kind of coins or credit instruments used to make exchanges; the
personal characteristics of wheat-traders such as the colour of
each trader's hair and eyes, his antecedents and education, the
number Of members of his family, their characteristics, antecedents,
and education, etc.; the kind of soil on which the wheat was grown,
its physical and chemical characteristics, the weather prevailing
during the growing season; the personal characteristics of the
farmers growing the wheat and of the consumers who will ultimately
use it; and so on indefinitely. Any attempt to move very far
in achieving this kind of “realism” is certain to render
a theory utterly useless.

Of course, the notion of a completely realistic theory is in part
a straw man. No critic of a theory would accept this logical
extreme as his objective; he would say that the “assumptions”
of the theory being criticised were “too” unrealistic
and that his objective was a set of assumptions that were “more”
realistic though still not completely and slavishly so. But so
long as the test of “realism” is the directly perceived
descriptive accuracy of the “assumptions” — for example,
the observation that “businessmen do not appear to be either
as avaricious or as dynamic or as logical as marginal theory portrays
them” or that ”it would be utterly impractical
under present conditions for the manager of a multi-process plant
to attempt . . . to work out and equate marginal costs and marginal
revenues for each productive factor” — there is no basis
for making such a distinction, that is, for stopping short of
the straw man depicted in the preceding paragraph. What is the
criterion by which to judge whether a particular departure from
realism is or is not acceptable? Why is it more “unrealistic”
in analysing business behaviour to neglect the magnitude of businessmen's
costs than the colour of their eyes? The obvious answer is because
the first makes more difference to business behaviour than the
second; but there is no way of knowing that this is so simply
by observing that businessmen do have costs of different magnitudes
and eyes of different colour. Clearly it can only be known by
comparing the effect on the discrepancy between actual and predicted
behaviour of taking the one factor or the other into account.
Eve the most extreme proponents of realistic assumptions are
thus necessarily driven to reject their own criterion and to accept
the test by prediction when they classify alternative assumptions
as more or less realistic.

The basic confusion between descriptive accuracy and analytical
relevance that underlies most criticisms of economic theory on
the grounds that its assumptions are unrealistic as well as the
plausibility of the views that lead to this confusion are both
strikingly illustrated by a seemingly innocuous remark in an article
on business-cycle theory that “economic phenomena are varied
and complex, so any comprehensive theory of the business cycle
that can apply closely to reality must be very complicated.”
A fundamental hypothesis of science is that appearances are deceptive
and that there is a way of looking at or interpreting or organising
the evidence that will reveal superficially disconnected and diverse
phenomena to be manifestations of a more fundamental and relatively
simple structure. And the test of this hypothesis, as of any
other, is its fruits — a test that science has so far met with dramatic
success. If a class of “economic phenomena” appears
varied and complex, it is, we must suppose, because we have no
adequate theory to explain them. Known facts cannot be set on
one side; a theory to apply “closely to reality,” on
the other. A theory is the way we perceive “facts,”
and we cannot perceive “facts” without a theory. Any
assertion that economic phenomena are varied and complex denies
the tentative state of knowledge that alone makes scientific activity
meaningful; it is in a class with John Stuart Mill's justly ridiculed
statement that “happily, there is nothing in the laws of
value which remains [1848] for the present or any future writer
to clear up; the theory of the subject is complete.”

The confusion between descriptive accuracy and analytical relevance
has led not only to criticisms of economic theory on largely irrelevant
grounds but also to misunderstanding of economic theory and misdirection
of efforts to repair supposed defects. “Ideal types”
in the abstract model developed by economic theorists have been
regarded as strictly descriptive categories intended to correspond
directly and fully to entities in the real world independently
of the purpose for which the model is being used. The obvious
discrepancies have led to necessarily unsuccessful attempts to
construct theories on the basis of categories intended to be fully
descriptive.

This tendency is perhaps most clearly illustrated by the interpretation
given to the concepts of “perfect competition” and “monopoly”
and the development of the theory of “monopolistic”
or “imperfect competition.” Marshall, it is said, assumed
“perfect competition”; perhaps there once was such a
thing. But clearly there is no longer, and we must therefore
discard his theories. The reader will search long and hard — and
I predict unsuccessfully — to find in Marshall any explicit assumption
about perfect competition or any assertion that in a descriptive
sense the world is composed of atomistic firms engaged in perfect
competition. Rather, he will find Marshall saying:, “At
one extreme are world markets in which competition acts directly
from all parts of the globe; and at the other those secluded markets
in which all direct competition from afar is shut out, though
indirect and transmitted competition may make itself felt even
in these; and about midway between these extremes lie the great
majority of the markets which the economist and the businessman
have to study”. Marshall took the world as it is, he sought
to construct an “engine” to analyse. it, not a photographic
reproduction of it.

In analysing the world as it is, Marshall constructed a hypothesis
that, for many problems, firms could be grouped into “industries” such that the similarities among the firms in each group were
more important than the differences among them. These are problems
in which the important element is that a group of firms is affected
alike by some stimulus — a common change in the demand for their
products, say, or in the supply of factors. But this will not
do for all problems: the important element for these may be the
differential effect on particular firms.

The abstract model corresponding to this hypothesis contains two
“ideal” types of firms: atomistically competitive firms,
grouped into industries, and monopolistic firms. A firm is competitive
if the demand curve for its output is infinitely elastic with
respect to its own price for some price and all outputs, given
the prices charged by all other firms; it belongs to an “industry”
defined as a group of firms producing a single “product.”
A “product” is defined as a collection of units that
are perfect substitutes to purchasers so the elasticity of demand
for the output of one firm with respect to the price of another
firm in the same industry is infinite for some price and some
outputs. A firm is monopolistic if the demand curve for its output
is not infinitely elastic at some price for all outputs.
If it is a monopolist, the firm is the industry.

As always, the hypothesis as a whole consists not only of this
abstract model and its ideal types but also of a set of rules,
mostly implicit and suggested by example, for identifying actual
firms with one or the other ideal type and for classifying firms
into industries. The ideal types are not intended to be descriptive;
they are designed to isolate the features that are crucial for
a particular problem. Even if we could estimate directly and
accurately the demand curve for a firm's product, we could not
proceed immediately to classify the firm as perfectly competitive
or monopolistic according as the elasticity of the demand curve
is or is not infinite. No observed demand curve will ever be
precisely horizontal, so the estimated elasticity will always
be finite. The relevant question always is whether the elasticity
is “sufficiently” large to be regarded as infinite,
but this is a question that cannot be answered, once for all,
simply in terms of the numerical value of the elasticity itself,
any more than we can say, once for all, whether an air pressure
of 15 pounds per square inch is “sufficiently” close
to zero to use the formula s = 1/2gt2. Similarly, we cannot
compute cross-elasticities of demand and then classify firms into
industries according as there is a “substantial gap in the
cross-elasticities of demand.” As Marshall says, “The
question where the lines of division between different commodities
[i.e., industries] should be drawn must be settled by convenience
of the particular discussion. Everything depends on the problem;
there is no inconsistency in regarding the same firm as if it
were a perfect competitor for one problem, and a monopolist for
another, just as there is none in regarding the same chalk mark
as a Euclidean line for on e problem, a Euclidean surface for
a second, and a Euclidean solid for a third. The size of the
elasticity and cross-elasticity of demand, the number of firms
producing physically similar products, etc., are all relevant
because they are or may be among the variables used to define
the correspondence between the ideal and real entities in a particular
problem and to specify the circumstances under which the theory
holds sufficiently well; but they do not provide, once for all,
a classification of firms as competitive or monopolistic.

An example may help to clarify this point. Suppose the problem
is to determine the effect on retail prices of cigarettes of an
increase, expected to be permanent, in the federal cigarette tax.
I venture to predict that broadly correct results will be obtained
by treating cigarette firms as if they were producing an identical
product and were in perfect competition. Of course, in such a
case, some convention must be made as to the number
of Chesterfield cigarettes “which are taken as equivalent”
to a Marlborough.

On the other hand, the hypothesis that cigarette firms would behave
as if they were perfectly competitive would have been a false
guide to their reactions to price control in World War II, and
this would doubtless have been recognised before the event. — Costs
of the cigarette firms must have risen during the war. Under
such circumstances perfect competitors would have reduced the
quantity offered for sale at the previously existing price. But,
at that price, the wartime rise in the income of the public presumably
increased the quantity demanded. Under conditions of perfect
competition strict adherence to the legal price would therefore
imply not only a “shortage” in the sense that quantity
demanded exceeded quantity supplied but also an absolute decline
in the number of cigarettes produced. The facts contradict this
particular implication: there was reasonably good adherence to
maximum cigarette prices, yet the quantities produced increased
substantially. The common force of increased costs presumably
operated less strongly than the disruptive force of the desire
by each firm to keep its share of the market, to maintain the
value and prestige of its brand-name, especially when the excess-profits
tax shifted a large share of the costs of this kind of advertising
to the government. For this problem the cigarette firms cannot
be treated as if they were perfect competitors.

Wheat farming is frequently taken to exemplify perfect competition.
Yet, while for some problems it is appropriate to treat cigarette
producers as if they comprised a perfectly competitive industry,
for some it is not appropriate to treat wheat producers as if
they did. For example, it may not be if the problem is the differential
in prices paid by local elevator operators for wheat.

Marshall's apparatus turned out to be most useful for problems
in which a group of firms is affected by common stimuli, and in
which the firms can be treated as if they were perfect
competitors. This is the source of the misconception that Marshall
“assumed” perfect competition in some descriptive sense.
It would be highly desirable to have a more general theory than
Marshall's, one that would cover at the same time both those cases
in which differentiation of product or fewness of numbers makes
an essential difference and those in which it does not. Such
a theory would enable us to handle problems we now cannot and
in addition, facilitate determination of the range of circumstances
under which the simpler theory can be regarded as a good enough
approximation. To perform this function, the more general theory
must have content and substance; it must have implications susceptible
to empirical contradiction and of substantive interest and importance.

The theory of imperfect or monopolistic competition developed
by Chamberlin and Robinson is an attempt to construct such a more
general theory. Unfortunately, it possesses none of the attributes
that would make it a truly useful general theory. Its contribution
has been limited largely to improving the exposition of the economics
of the individual firm and thereby the derivation of implications
of the Marshallian model, refining Marshall's monopoly analysis,
and enriching the vocabulary available for describing industrial
experience.

The deficiencies of the theory are revealed most clearly in its
treatment of, or inability to treat, problems involving groups
of firms — Marshallian “industries.” So long as it is
insisted that differentiation of product is essential — and it is
the distinguishing feature of the theory that it does insist on
this point — the definition of an industry in terms of firms producing
an identical product cannot be used. By that definition each firm
is a separate industry. Definition in terms of “close”
substitutes or a “substantial” gap in cross-elasticities
evades the issue, introduces fuzziness and undefinable terms into
the abstract model where they have no place, and serves only to
make the theory analytically' meaningless — “close” and
“substantial” are in the same category as a “small”
air pressure. In one connection Chamberlin implicitly defines
an industry as a group of firms having identical cost and demand
curves. But this, too, is logically meaningless so long as differentiation
of product is, as claimed, essential and not to be put aside.
What does it mean to say that the cost and demand curves of a
firm producing bulldozers are identical with those of a firm producing
hairpins? And if it is meaningless for bulldozers and hairpins,
it is meaningless also for two brands of toothpaste — so long as
it is insisted that the difference between the two brands is fundamentally
important.

The theory of monopolistic competition offers no tools for the
analysis of an industry and so no stopping place between the firm
at one extreme and general equilibrium at the other. It is therefore
incompetent to contribute to the analysis of a host of important
problems: the one extreme is too narrow to be of great interest;
the other, too broad to permit meaningful generalisations.

VI. Conclusion

Economics as a positive science is a body of tentatively accepted
generalisations about economic phenomena that can be used to predict
the consequences of changes in circumstances. Progress in expanding
this body of generalisations, strengthening our confidence in
their validity, and improving the accuracy of the predictions
they yield is hindered not only by the limitations of human ability
that impede all search for knowledge but also by obstacles that
are especially important for the social sciences in general and
economics in particular, though by no means peculiar to them.
Familiarity with the subject matter of economics breeds contempt
for special knowledge about it. The importance of its subject
matter to everyday life and to major issues of public policy impedes
objectivity and promotes confusion between scientific analysis
and normative judgment. The necessity of relying on uncontrolled
experience rather than on controlled experiment makes it difficult
to produce dramatic and clear-cut evidence to justify the acceptance
of tentative hypotheses. Reliance on uncontrolled experience
does not affect the fundamental methodological principle that
a hypothesis can be tested only by the conformity of its implications
or predictions with observable phenomena; but it does render the
task of testing hypotheses more difficult and gives greater scope
for confusion about the methodological principles involved. More
than other scientists, social scientists need to be self-conscious
about their methodology.

One confusion that has been particularly rife and has done much
damage is confusion about the role of “assumptions”
in economic analysis. A meaningful scientific hypothesis or theory
typically asserts that certain forces are, and other forces are
not, important in understanding a particular class of phenomena.
It is frequently convenient to present such a hypothesis by stating
that the phenomena it is desired to predict behave in the world
of observation as if they occurred in a hypothetical and
highly simplified world containing only the forces that the hypothesis
asserts to be important. In general, there is more than one way
to formulate such a description — more than one set of “assumptions”
in terms of which the theory can be presented. The choice among
such alternative assumptions is made on the grounds of the resulting
economy, clarity, and precision in presenting the hypothesis;
their capacity to bring indirect evidence to bear on the validity
of the hypothesis by suggesting some of its implications that
can be readily checked with observation or by bringing out its
connection with other hypotheses dealing with related phenomena;
and similar considerations.

Such a theory cannot be tested by comparing its “assumptions”
directly with “reality.” Indeed, there is no meaningful
way in which this can be done. Complete “realism” is
clearly unattainable, and the question whether a theory is realistic
“enough” can be settled only by seeing whether it yields
predictions that are good enough for the purpose in hand or that
are better than predictions from alternative theories. Yet the
belief that a theory can be tested by the realism of its assumptions
independently of the accuracy of its predictions is widespread
and the source of much of the perennial criticism of economic
theory as unrealistic. Such criticism is largely irrelevant,
and, in consequence, most attempts to reform economic theory that
it has stimulated have been unsuccessful.

The irrelevance of so much criticism of economic theory does not
of course imply that existing economic theory deserves any high
degree of confidence. These criticisms may miss the target, yet
there may be a target for criticism. In a trivial sense, of course,
there obviously is. Any theory is necessarily provisional and
subject to change with the advance of knowledge. To go beyond
this platitude, it is necessary to be more specific about the
content of “existing economic theory” and to distinguish
among its different branches; some parts of economic theory clearly
deserve more confidence than others. A comprehensive evaluation
of the present state of positive economics, summary of the evidence
bearing on its validity, and assessment of the relative confidence
that each part deserves is clearly a task for a treatise or a
set of treatises, if it be possible at all, not for a brief paper
on methodology.

About all that is possible here is the cursory expression of a
personal view. Existing relative price theory, which is designed
to explain the allocation of resources among alternative ends
and the division of the product among the co-operating resources
and which reached almost its present form in Marshall's Principles of Economics, seems to me both extremely fruitful and deserving
of much confidence for the kind of economic system that characterises
Western nations. Despite the appearance of considerable controversy,
this is true equally of existing static monetary theory, which
is designed to explain the structural or secular level of absolute
prices, aggregate output, and other variables for the economy
as a whole, and which has had a form of the quantity theory of
money as its basic core in all of its major variants from David
Hume to the Cambridge School to Irving Fisher to John Maynard
Keynes. The weakest and least satisfactory part of current economic
theory seems to me to be in the field of monetary dynamics, which
is concerned with the process of adaptation of the economy as
a whole to changes in conditions and so with short-period fluctuations
in aggregate activity. In this field we do not even have a theory
that can appropriately be called “the” existing theory
of monetary dynamics.

Of course, even in relative price and static monetary theory there
is enormous room for extending the scope and improving the accuracy
of existing theory. In particular, undue emphasis on the descriptive
realism of “assumptions” has contributed to neglect
of the critical problem of determining the limits of validity
of the various hypotheses that together constitute the existing
economic theory in these areas. The abstract models corresponding
to these hypotheses have been elaborated in considerable detail
and greatly improved in rigour and precision. Descriptive material
on the characteristics of our economic system and its operations
have been amassed on an unprecedented scale. This is all to the
good. But, if we are to use effectively these abstract models
and this descriptive material, we must have a comparable exploration
of the criteria for determining what abstract model it is best
to use for particular kinds of problems, what entities in the
abstract model are to be identified with what observable entities,
and what features of the problem or of the circumstances have
the greatest effect on the accuracy of the predictions yielded
by a particular model or theory. Progress in positive economics
will require not only the testing and elaboration of existing
hypotheses but also the construction of new hypotheses. On this
problem there is little to say on a formal, level. The construction
of hypotheses is a creative act of inspiration, intuition, invention;
its essence is the vision of something new in familiar material.
The process must be discussed in psychological, not logical,
categories; studied in autobiographies and, biographies, not treatises
on scientific method; and promoted by maxim and example, not syllogism
or theorem.